The world financial markets continue to examine the fundamental pillars of global and domestic banks in the wake of the perpetual changing international economic and political environment. Islamic financial institutions, on the contrary, are demonstrating resilience as global events continue to reshape the landscape of global financial services. The true test, however, will be the way through which Islamic finance industry prepares itself for the opportunities and challenges thrown up by such a rapidly changing global economy. DR HYLMUN IZHAR and YAHYA A REHMAN analyze where the industry stands now, and forecast its future in today’s volatile environment.
While various reports suggest slightly different figures on the size of Islamic finance industry as a whole; it is believed that the industry witnessed assets rise for the seventh consecutive year since it began collecting data in 2006, climbing from US$1.2 trillion in 2012 to US$1.3 trillion in 2013, or 8.7% annual growth. Such data is based on disclosed assets by all Islamic finance institutions (fully Shariah compliant as well as those with Shariah windows) covering commercial banking, funds, Sukuk, Takaful, and other segments. The breakdown by category is as follows: US$985 billion for commercial banking, US$251 billion for Sukuk, US$44 billion for Islamic funds, and US$26 billion for Takaful.
It is also revealed that while the growth of the industry last year saw a slowdown from 20.7% in 2012 to 8.7% in 2013, the compound annual growth rate since 2006 remains a healthy 16%. In addition, the estimated US$628 million of Islamic microfinance assets also represents a growing segment although only accounting for about 0.8% of the estimated total global microfinance market of US$78 billion.
Such positive growth and development prospects, one way or the other, have accelerated the eastward shift in the world’s economic center of gravity. Economies of the Middle East and Asia — including key Muslim member countries — are seen as increasingly vital. The G20 — a summit that plays a key role in international economic policy — now includes three Islamic Development Bank (IDB) and Organisation of Islamic Cooperation (OIC) member countries (Indonesia, Turkey, and Saudi Arabia).
This eastward shift creates numerous opportunities for the Islamic finance industry: including (a) managing the savings and wealth being created, (b) supporting ongoing economic growth by providing financing, and (c) exercising increased influence in global forums and decision-making bodies. These global forums include both forums that have traditionally been dominated by western economies (such as the G20, IMF, and World Bank) and new forums that provide greater focus on emerging economies in Asia, the Middle East, and Africa.
Since 2008, the world has also witnessed waves of successive financial crises. Ranging from institutional crises (e.g. the failure of Lehman Brothers) to systemic crises (e.g. the virtual collapse of European debt markets) to sovereign debt and currency crises (e.g. fundamental challenges to the Eurozone), the very pillars of the global financial system have been shaken up.
The ongoing financial crises have certainly prompted a high level of re-questioning of the conventional financial system. This creates an unprecedented opportunity for the Islamic finance industry to contribute to a global dialogue on the very nature of the robust and resilient financial system which would, hopefully, generate developmental impact on the society.
This opportunity has been further bolstered by (a) the increased clout of OIC member countries; and (b) the active attention the industry has already received in international commentaries on the financial system. Some observers believe the Islamic finance industry has not played an active enough role in the dialogue — further underscoring the present opportunity. Important international organizations such as the IDB and OIC can consider a targeted strategy to work with the three G20 members — Turkey, Indonesia, and Saudi Arabia — to help bring Islamic finance more strongly to this forum.
Indeed, contributing to the global dialogue can not only boost the industry itself, but it can also pave the way for the Islamic finance industry to have a genuine impact on the broader financial system by sharing and transferring valuable principles.
Where does the industry currently stand?
Many are of the view that the Islamic finance industry commenced with an introduction of Islamic banks in the mid-1970s. In the very beginning stage, the operationalization of Islamic banks were underpinned by the principle of two-tier Mudarabah: that is on the liabilities side of the balance sheet, the depositor would be the financier and the bank the entrepreneur; and on the assets side, the bank would be the financier and the person seeking funding for the entrepreneur. However, after having gone through ‘a four-stage evolution’; the operationalization of Islamic banks which dominates the Islamic finance industry has essentially moved from ‘two-tier Mudarabah’ to ‘two-tier Murabahah’, whereby the bulk of assets and liabilities sides of Islamic banks are predominantly inhabited by Murabahah modes of finance.
More than four decades after its inception; the important question is now: “Where does the Islamic finance industry currently stand?” In spite of impressive growth over the last few years as stated earlier; the Islamic finance industry (consisting of four main sectors: namely Islamic banking, Islamic capital markets, Takaful and re-Takaful, non-bank financial institutions (such as investment banks, asset management companies, securities firms, leasing companies) and microfinance institutions) is currently characterized by the following:
a) Considerably higher cost of transactions
A higher cost of transactions is one of the major unresolved issues in Halal finance industry. Some would say that this happens due to the economics of scale that the industry has not yet attained. Others might contend that the problem arises because of a lack of legal and regulatory harmonization, which contributes to an uneven playing field leading to higher cost of transactions in Islamic financial products. Notwithstanding such arguments, this requires a solid solution, particularly in the area of home financing which is considerably ubiquitous in many Muslim countries and also for the Muslim communities living in non-Muslim countries.
b) Limited options of risk management instruments, mitigation techniques and quantitative measurement models
Despite the prominent initiatives by the IFSB in issuing guidelines relating to risk management, stress testing and capital adequacy standard; a more detail technical guidance which features the techniques and methodologies of risk assessment taking into account unique risks in Islamic financial institutions is still required.
Furthermore, it was also commonly understood that whilst the definition of risks in Islamic financial institutions is not substantially different from the ones in their conventional counterparts, a modification in the identification, measurement and mitigation of risks may be required due to some Shariah principles. More importantly, there is an urgent need to develop a proper legal environment and suitable regulatory framework need to sound practice of risk management in Islamic financial institutions.
In addition, limited liquidity instruments for Islamic capital markets are another challenge. In response to this the International Islamic Liquidity Management (IILM) recently successfully launched the ‘Golden Triangle Sukuk’ featuring a connection between financial stability, economic development, and debt management.
c) Restricted legal and regulatory framework
A daunting task for the Islamic finance industry stakeholders is not only to establish regulatory harmonization between different jurisdictions; but also to conform with the standards and guidance set out by international standard-setting bodies such as BCBS (Basel Committee on Banking Supervision), IOSCO (International Organization of Securities Commision) and the IFRS (International Financial Reporting Standards). Surely, the idea of ‘one size fits all’ is not viable due to the fact that different countries have different institutional and regulatory frameworks.
d) Lack of Islamic monetary policies
At the macro level, the availability of Islamic monetary instruments is indispensable to support the macroeconomic objectives of the Islamic financial system. Another important element of such an instrument is for the purpose of liquidity management. Some countries have initiated the creation of such instruments, such as in Indonesia and Malaysia. However, more efforts need to be undertaken to also allow inter-jurisdictional transactions and liquidity management between the countries implementing interest-free financial system.
e) Financial inclusion gap
Financial inclusion is a concept that gained its importance since the early 2000s, which initially referred to the delivery of financial services to low-income segments of society at affordable cost. However, two distinct features which characterize the concept of financial inclusion from an Islamic perspective are two-fold: a) the notions of risk-sharing, and b) redistribution of wealth. Although there is a strong demand for Islamic microfinance services in OIC countries, it is nevertheless not met by the supply. A study by Mohieldin et al. (2010) shows that although OIC countries have more microfinance deposits and accounts per thousand adults as compared to non-OIC countries, the values of MFI deposits and loans as percentage of GDP are still much lower in OIC countries (0.61% and 0.79%) compared with developing countries (0.78% and 0.97%) and low income countries (0.92% and 1.19%). The gap of microfinance in OIC is not only demonstrated by its limited scope, but also by the lack of regulation in OIC countries compared to other developing countries. In MENA region for example, only Egypt, Morocco, Syria, Tunisia, and Yemen have specific legislation for microfinance institutions.
f) Lack of human capital enhancement
The continuing growth and intensified competition among market players in the Islamic finance industry has certainly posed quantitative and qualitative human resource problems for the industry. It does not come as a surprise, therefore, that the industry needs more and better-qualified personnel, which, unfortunately is rather in short supply. An establishment of visionary polices and initiatives to respond to this matter will definitely be useful. Furthermore, such policies and initiatives are in line with recommendation No. 5 of the ‘10-Year Framework and Strategies for Islamic Financial Services Industry Development’ which aims to: “Develop the required pool of specialized, competent and high caliber human capital.”
g) Perceptions about Islamic finance
Many still think that Islamic finance is basically an industry designed by Muslims and offered to solely Muslims market only. Although it appears to be partially the case, nonetheless, the key spirit of Islamic finance is totally a lot more profound than what has been stated. As a matter a fact, take an example of interest (Riba) prohibition; it is shared with Judaism and Christianity. It is also interesting to note that charging interest is also prohibited in Buddhism, Hinduism, and many other faiths and philosophies.
What are the future trends?
Despite the existing and foreseeable challenges, the prognosis for Islamic finance seems to be positive, validating the assertion that Islamic finance has become mainstream and is here to stay and grow.
Renewed interest is being witnessed from the west, as can be seen from the recent announcement by the UK of a sovereign Sukuk and a reiteration of the desire by multiple cities to position themselves as the ‘global hub’ of Islamic finance. Within the Middle East, capitals such as Dubai, Doha and Manama remain keen to retain their identity as a center of Islamic finance. In fact, Dubai has gone one step ahead and declared its intention to become the capital of the Islamic economy. Further afield, Kuala Lumpur remains committed as the trailblazer for Islamic finance and the Halal economy.
This shift from mere banking and finance to the broader Islamic or Halal economy is interesting in that it has not only expanded the size of opportunity manifold, it also proposes to create a link between Islamic finance and the real economy including sectors as diverse as hospitality, media, clothing, food and lifestyle.
In addition to the heightened interest from these somewhat more traditional centers of Islamic finance, the most encouraging signs of the proliferation of Islamic finance are coming from Turkey, Africa, and Central Asia where emerging and transition economies are embracing Islamic finance not only as a means of raising capital for infrastructure projects but as mainstream retail banking, finance and insurance. The fact that the World Bank has chosen Istanbul as the location for its center of excellence in Islamic finance is indicative of the shift to new markets and frontiers for Islamic finance.
While Islamic finance remains set for growth and expansion, a trend that can be expected to endure in the short to medium-term is the variation of performance across sectors. Banking and Sukuk will continue to dominate the industry in terms of size. Islamic funds and Takaful, on the other hand, while growing steadily; will see growth remain modest in terms of the overall share. Although some see this as a challenge, this also presents a great opportunity. As the link between the real and nominal economy becomes more pronounced these sectors are bound to become more prominent.
Another very positive development in the Islamic finance industry is the reorientation towards social objectives and financial inclusion. This is driven by both push and pull factors. Where on one side, a need is being felt to respond to the criticism that Islamic finance has failed to deliver on its promises on fairness, equity and inclusion; there is also a genuine demand and opportunity in the wake of the Arab Spring and the ongoing global recession to redirect innovation towards services and products that create more economic opportunities, jobs and financial inclusion for those who hitherto have been on the sidelines of the Islamic finance revolution.
Islamic microfinance, crowd funding, SME finance etc. are now the buzzwords at Islamic conferences and symposia. Academicians, researchers and practitioners are increasingly focusing on developing new and innovative Islamic financial products and solutions that can make a real difference to the common man. Competitions, grants and awards are being established to incentivize the brightest minds to take up the challenge. This trend bodes well for the realignment of Islamic finance with the Maqasid Al Shariah, a critical link that many deem was broken as Islamic finance pursued an agenda of emulating a permissible version of conventional finance with little attention to the broader purpose and objectives of an Islamic economy.
With the above trends poised to continue over the short to mid-term, two associated factors will be critical. First: product innovation. As outlined above, there is a dire need for new solutions and products to existing and emerging needs. So far product innovation and financial engineering in Islamic finance has been limited, cautious and mostly on the lines of replication of what are existing and prevalent conventional products. While this may have been acceptable as a starting point, it seems to have run its course. Product innovation now needs to go beyond tweaking and juxtaposing of existing contracts to look at newer and more imaginative ways of delivering what is being demanded by the market. Islamic financial engineering needs to move beyond Shariah compliant variants of conventional products to more authentic and original Islamic financial products and solutions that are rooted in true Islamic spirit and tradition. These products should be the true differentiation of Islamic finance and a real value addition to addressing the social and economic challenges faced by the Muslim and wider world.
Second, as Islamic finance expands to new territories and jurisdictions, and gets more connected to the global Islamic economy, harmonization of Shariah, legal and regulatory rules will become even more critical. This is to ensure that cross-border transactions costs are low and the industry is able to be efficient and competitive. This in turn means that governments and regulators need to think less in terms of competition and more on the lines of collaboration and cooperation. While regional, national and local variations will exist, these should add to the richness of Islamic finance and not become a hindrance to its proliferation. This therefore is not only the biggest challenge but also the greatest opportunity.
The way forward
The fact that Islamic finance has been a thriving phenomenon requires further examination in strategizing the policies and initiatives; and more importantly to ensure that the values are preserved and resonated across all components of Islamic financial system. It is, therefore, suggested that the areas which necessitate particular consideration in the years to come are as follows:
a) Promoting equity-based finance and strengthening the linkage between the real and financial sectors
Islamic finance may have made significant progress from the early days but so far it has constrained itself mostly to debt-like instruments derived mainly from trade-based contracts such as Murabahah, Ijarah, Istisnah and Salam. With the maturity of the market, institutions and players, the need now is to embrace the true spirit of sharing risk and rewards and move to more equity based finance. Hence, the development of market infrastructures to support such an initiative can’t be lagged behind. This, as a result, will not only help differentiate and distance Islamic finance from the allegations of being ‘conventional finance in a different guise’ but also enable it to serve and expand in areas where it is currently falling short. Greater sharing of risk would inevitably require greater involvement, oversight and participation in the real economy and further development of risk management techniques but this is exactly what Islamic finance needs to do now.
b) Enhancing financial inclusion
The emerging interest and initiatives in microfinance are undoubtedly both exciting and consistent. Nevertheless, as described earlier, the so called ‘financial inclusion gap’ is still prevalent. Therefore, innovative and diversifications of microfinance products need to be created and enhanced to allow the underprivileged society to benefit from such endeavor. More importantly; it will also enable an equitable distribution. Concurrently, it also makes a lot of sense if such initiatives are also coupled with the development of Takaful and microTakaful sector as part of the cushion component of the Islamic finance industry.
c) Promoting the revitalization of Zakat and Waqf
In recent times Zakat and Waqf, unfortunately, have been seen as primitive, inefficient and even, in places, as corrupt institutions that have outlived their utility and failed to deliver to their beneficiaries. It is true that there are significant challenges, not least regarding legal and regulatory issues, to the rehabilitation of these institutions. However, the potential that these institutions possess in terms of reach, diversity and inclusion outweighs any efforts that may be required to bring these back to the mainstream.
In this regard, visionary policies and solid initiatives need to be set out to foster a stronger collaboration among countries and international strategic stakeholders to promote an institutionalization of these redistributive instruments so that the modernization and rehabilitation of Zakat and Waqf as formidable institutions of Islamic finance can be attained. Furthermore, such a transformation is needed to ensure that real change is brought about through financial inclusion.
d) Harmonizing legal and regulatory frameworks and monetary policies
At the macro and governmental level, there is now more than ever the need for an enabling environment to support the growth of Islamic finance. We previously highlighted the need to create greater harmonization and coordination across legal and regulatory jurisdictions. Equally important are measures by governments that are keen to promote Islamic finance so that the playing field remains level and conducive in terms of fiscal and monetary policies, tax rules, supervision and reporting, so that Islamic finance can compete from a position of strength. It is also important to note that as market infrastructures become more developed across jurisdictions, they will eventually pave the way for the possibility of cross-border transactions and liquidity management.
e) Conducting a periodic assessment of the Islamic finance industry and its impact on the society at large
The Islamic finance industry, which started at a modest scale in 1970s, has demonstrated tremendous growth over the last four decades. It has been identified as one of the fastest-growing industries in the world, with double-digit growth in the last few years. As such, this has prompted questions over the factual magnitude of the industry; interconnection and interdependence between sectors within the industry; and more importantly the impact of the industry on the society at large. It is suggested that various jurisdictions might have different levels of development. In addition, it is believed that various sectors in the Islamic finance industry are growing at different speed levels. Through comprehensive and methodical assessments, a set of right policies and initiatives, hence, can be formulated to further drive the development and transformation of the Islamic finance industry.
f) Rebranding Islamic finance
The fundamental essence of Islam is its universality and the fact that it transcends time, place and people. The prophet Muhammad was sent as a mercy to the world. Islamic finance in its true form is a financial ideology that is grounded in the principles of justice, fairness, compassion, honesty, equity, sharing and inclusion. These divine principles also transcend time, place and people and as such have been emphasized not only in all Abrahamic monotheistic religions but are cherished across all civilizations and humans. The need therefore is to highlight not the exclusivity of Islamic finance but the universality of its appeal as an ethical, socially responsible and fair system of finance not just for Muslims but for the whole world.
Dr Hylmun Izhar is an economist and Yahya Rehman heads the advisory services at the Islamic Research and Training Institute of the IDB. They can be contacted at
views expressed in this article are those of the authors and do not necessarily represent the views of, and should not be attributed to the IDB.